The conventional wisdom leading into last month’s U.S. presidential election held that in the unlikely event that Donald Trump was victorious, a significant market sell-off would likely ensue. Early financial market indicators on election night certainly fit this scenario as Dow Jones Industrial Average futures fell over 800 points in overnight trading. However, by the morning bell the following day, the broad U.S. market had recovered most of its losses. The U.S. equity market has moved past its early election night jitters onto new all-time highs as signs of investor bullishness are returning. The markets have welcomed the surprise outcome embracing the potentially pro-growth elements of Donald Trump’s campaign (e.g., tax reform, fiscal stimulus, deregulation, etc.), coupled with the possibility of enacting them with Republican majorities in the House of Representatives and the Senate. This research note seeks to step beyond the near-term headlines (and tweets) and contemplate the following question:
Does the election of Donald Trump plus a Republican majority in the House and Senate equate to a change in our slow growth overview?
Before contemplating this question, it is worthwhile to review the key drivers of the slow-growth overview we have held throughout the current economic expansion. These drivers are:
- Significant amount of debt around the world incurred prior to the financial crisis that would pull forward future demand, resulting in lower growth this cycle.
- Poor demographics in many developed markets (aging of society, declining labor forces) that would result in slower economy-wide output growth.
- Increasing regulation and rising policy uncertainty that would have a restraining effect on business confidence and investment spending.
Today, global debt balances remain high and the demographic picture is little changed globally. While the recent election result in the U.S. raises the prospects for improved confidence and business spending, it would be difficult to envision sustainably higher growth and inflation without governments pursuing true structural reform and/or undertaking a definitive shift in policy. We do, however, believe that recent economic developments—such as a tick up in energy investment, improving wage growth, and government spending moving from a headwind to a tailwind—combined with potential pro-growth policies of the incoming administration could be supportive of a cyclical pick-up in growth and inflation at the margin, particularly in the U.S. While we expect growth will remain secularly challenged, today there now exists a potential cyclical risk to the upside. Although it is a subtle change, it is a shift in our directional assessment of the risks to economic growth.
Odds of a traditional economic cycle have increased
We have been monitoring the risk of the current economic expansion simply dying out of old age as opposed to the typical pattern of overheating prior to recession. Today, we believe that a cyclical upside scenario to the United States economy could exist, in which a more orthodox cycle takes hold. We believe the C, I, and G (i.e., Consumption, Investment, and Government Spending) components of U.S. GDP growth are likely to see tailwinds to growth unfold:
- Consumption: Consumption continues to be supported by strong employment and wage growth. Tax cuts would further be supportive of additional upside for consumer spending.
- Investment: Improved corporate profitability driven in part by tax cuts combined with regulatory reform
hold the potential to boost business confidence and in turn investment spending.
- Government: Government spending had already moved from a headwind to a tailwind. The election of
Donald Trump further increases the probability of additional fiscal spending targeted at infrastructure
It is important to note most of the effects of these policies on GDP are unlikely to be felt for a year or more, even if successfully implemented. In the meantime, it will be important to keep a close eye on consumer and business confidence to gauge the willingness to spend/invest in anticipation of better future prospects.
Conspicuously absent from our GDP math discussion thus far is the trade component. This is clearly the biggest wildcard, with the largest potential downside risk to growth. Protectionist trade and limits on immigration are likely to weigh on growth if implemented. We will be monitoring signs of protectionist trade policies closely.
We believe expansionary fiscal policy and the likelihood of protectionist trade policies will likely cause inflation expectations to stay elevated from here. The stronger case for global inflation will also be meaningful as the period of importing deflation may be coming to an end. The global economy had been recovering in the months prior to the election from the disinflationary supply shock that occurred in the commodity complex over the past few years. The base effects in oil and commodity prices, combined with a tighter labor market and building wage pressures in the U.S., signaled a bottom in inflation.
The backdrop of a cyclical pick-up in growth, higher inflation, and shifts in policy toward fiscal (with less emphasis on monetary) in the U.S. (and potentially globally) would support higher bond yields. We believe central banks have acknowledged the decreasing marginal benefit of further monetary accommodation from existing levels, and the negative impacts (i.e., weaker bank profitability, higher savings rates) may more than offset the positive impact of lower borrowing costs. Hence, we anticipate a broader paradigm shift globally toward fiscal policy to boost growth.
Risk of volatility has not diminished
It is no secret that markets prefer certainty over uncertainty. Judging by the post-election market moves in the U.S., it would seem that certainty abounds. The market has rallied to new highs, awarding what seem to be full marks to the potentially growth-boosting elements of the incoming president’s economic platform while giving few demerits to the risk entailed by other aspects of his campaign message. Specifically, we are referring to the risk of negative consequences associated with the trade and immigration policies that President-elect Trump may implement. All else equal, barriers to free mobility of labor and capital can be expected to reduce growth and lower expected returns on capital. Furthermore, protectionism is typically
inflationary. We currently have little clarity on how pragmatic or populist Trump’s administration will be in pursuing a restructuring of existing trade agreements. While the U.S. stock market has paid little attention to this matter thus far, we believe that it is a material risk to equity markets and one that we are monitoring closely. Clearly this has already had a material impact on Mexico.
The latest move by Congress to try and pass the Border Adjustability Tax within the overall Tax reform plan is a bit concerning in that it may be a sign that House Republicans may not restrain Trump’s protectionist plans. The rise of populist candidates and rhetoric is not just a U.S. phenomenon. We are monitoring elections around Europe where other candidates expressing nationalistic/protectionist messages have garnered meaningful support. Ultimately, we are not in the business of predicting election outcomes; however, at a time when the VIX is only a few points off its lows for the past 5 years and investor sentiment is increasingly complacent (if not outright bullish), we feel that any unwelcome surprise is likely to be met with another bout of market volatility.
Our recommended equity/fixed income allocation is unchanged in the face of these developments. A neutral to modest underweight allocation to stocks remains appropriate given our overall market return expectations have not been meaningfully altered as equity valuations are not compelling. Furthermore, if bond yields continue to move higher, they may become an increasingly worthy alternative for stocks again in the minds of more investors. It is true that some elements of the President-elect’s policies should be pro-growth (lower taxes, less regulation); however, the timing and extent to which they are successful are unknown. Additionally, other policy proposals introduced are likely to inject new risks into the markets. While higher yields have been negative for fixed income returns, our shorter duration positioning has benefitted from the current backup in yields on a relative basis. If rates continue to rise, we will likely seek to increase duration exposure at the margin.
To be clear, we are not making a call that U.S. or global growth is “off to the races” or set to accelerate back to pre-global financial crisis levels. Secular drags to growth from demographics and high global debt burdens remain intact. A change to our longer-term secular outlook would require governments globally following through on structural reforms that lead to increased productivity, allowing the world to grow into its current debt position. Our current recommended allocation provides a significant amount of flexibility to increase equity exposure should our indicators become more favorable. Ultimately, we remain in the same mindset that we have had for some time now: that flexibility in asset allocation is essential both to take advantage of market volatility as well as for navigating the risks posed at times by investor complacency and elevated valuations.